Insurance transfer tax-planning “loophole” now closed

The first budget from Prime Minister Justin Trudeau’s government has closed a perceived “loophole” in tax planning – one that’s been a target of successive Finance ministers under both Conservative and Liberal governments. The target was the ability of advisors and their clients to rely on the provisions of section 148 of the Income Tax Act to extract funds tax-free (or close to it) from a corporation, by transferring life insurance policies to their corporations.

The old rules: use insurance policies to extract tax-free funds

Under the old rules, policyholders could transfer a life insurance policy, term or permanent, from an individual shareholder to their corporation (where a non-arm’s-length relationship exists) and receive a consideration equal to the fair market value of the policy in exchange. The proceeds of disposition were deemed to be equal to the cash surrender value (CSV) of the transferred policy at the time of disposition, and you were then taxed on the difference between the CSV and the policy’s adjusted cost base. As a result, the amount by which the fair market value exceeded the CSV was paid out without further taxation.

The provisions of the federal government’s 2016 budget, released March 22, include proposed changes that will affect transfers of permanent policies that take place both prior to and after Budget Day of March 22, 2016.

Transfers after March 22, 2016
Starting on Budget Day, taxpayers will no longer be able to receive the excess of the fair market value of a policy disposed of to a corporation or partnership over its cash surrender value as a tax-free benefit when the policy is transferred to a corporation or partnership.

Transfers prior to March 22, 2016
In cases where a policy was transferred to a corporation or partnership prior to Budget Day, a similar measure will apply to reduce the amount added to a capital dividend account, paid-up capital and/or the adjusted cost base.

From a tax planning perspective, these changes mean that going forward, clients and advisors can no longer rely on the transfer of an insurance policy to minimize tax. But what do the changes mean for transfers that have already taken place?

Planning opportunities – and needs – remain

“The new rules mean the need for effective tax planning is as acute as ever,” comments Trevor Parry, president at TRP Strategic Consulting, a strategic planning firm providing expertise in areas including owner-manager remuneration.

“For an owner-manager who engaged in this strategy prior to Budget Day and who is now faced with a new taxation regime, there are some choices to make. Under the Liberal proposals, the Capital Dividend Account (CDA) amount will be reduced by the amount by which the fair market value exceeded the cash surrender value, also known as the ‘benefit amount.’”

“What this means is that if your client extracted funds from their corporation as a result of the transfer of a policy to the corp, upon the death of the insured they will now see a corresponding reduction in CDA, equal to the amount they got out at the time of transfer. Going forward, the effects of this change might still be mitigated by planning that took place at the time of transfer, or planning that you and your client can engage in now. For instance, your client may have intended to utilize only part of the CDA credit in order to avoid the stop-loss rules, or they may intend to pay out the non-CDA amount as a taxable dividend, which is preferable to income.”

“It’s also important to keep in mind that your client still benefited from the transfer, even though the rules have now changed – because they were able to extract and use funds from their policy tax-free. Finally, given these changes, advisors and clients should take care to re-examine succession plans to make sure adequate coverage is in place to cover potential CDA credit reductions.”